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Markets: The Exception
New York: July 07, 2008
By John R. Stephenson

Suddenly the sludge from the U.S. banking crisis is at our back door. Markets have been anything but stable, as Wall Street's credit crunch continues to hobble most of the world's stock markets. Markets are down, inflation is up and your nest egg is shrinking. So what's a prudent investor to do?

Relax! And then come up with a plan that capitalizes on what has been working in these uncertain times — energy and agricultural stocks.

Focusing your portfolio on high-flying commodity stocks is a risky bet for sure, but for the last few years, has been the only sensible one to make. With the US in a full-fledged bear market, most of the world's equity markets have suffered steep losses. Canada's Toronto Stock Exchange ("S&P/TSX") with its heavy resource weighting, has been an exception, but even on the S&P/TSX winners have been hard to find.

Soaring prices for metals, oil and fertilizers have helped propel Canada's benchmark equity index higher. With strong commodity prices, Canada's S&P/TSX index is among the world's best performing stock exchanges over the last five years. But all this comes with more than a little bit of risk. The energy and materials sectors of the market now represent more than half the market capitalization! Talk about putting all of your eggs in one basket.

While sky-high commodity prices may be a good thing for Canadian investors, they are wrecking havoc just about everywhere else as inflationary pressures have curbed growth around the globe. With the European Central Bank hiking rates a quarter point last week, inflation is once again back in the spotlight.

And with inflation on the rise and central bankers in Europe and America poised to start tightening monetary policy, economic growth in these two regions is likely to be anemic. That's good news for Canada and its commodity-weighted stock exchange, as all of a sudden Canada starts to look like a pretty good place to invest.

The growth in China and India has been the driving force behind the rising cost of base metals. But with inflation running amok, will China and India follow Europe's lead and slow economic growth in order to tame inflation? Not likely! Economic history suggests that only rich economies can afford the luxury of slowing domestic growth to slice a few percentage points off the CPI.

In much of the oil producing areas of the world the story is similar — inflation is everywhere. For some oil exporting nations, their currencies are pegged, or float within a narrow band, to the slumping US dollar. The gain on an increase in the price of crude/barrel is sometimes offset for these oil-exporting countries by a fall in the US dollar. In order to combat a decline in the US dollar, many of these nations might look to loosen their pegs to the dollar in the years ahead. This would help dampen domestic inflation, but is unlikely to curb growth dramatically with oil prices on fire.

Figure 1: Inflation Everywhere!

Source: CIBC WorldMarkets Inc.

For energy investors, there may be more good times ahead. While oil prices have soared above $140/barrel, marking a 45% gain so far this year, the energy equities on the Toronto Stock Exchange have "only" risen by 20%, suggesting that before all is said and done, energy stocks may have further to run. Last year, the story was much the same. Crude oil prices were up 60% in 2007, yet share prices for oil and gas companies were up a meager 5% on the S&P/TSX.

If energy and agriculture are the places to be, what should investors avoid? For our money, a bet on the financials is one you might want to avoid. With inflation on an upswing and central bankers in a tightening mode, financials are not where you want to be. The stocks of financial companies tend to get hit in a rising interest rate environment since their loan losses tend to climb as interest rates go up.

While it may be difficult to stomach, weighting your portfolio toward what is working, rather than what has worked in the past is the bet to be taking. For our money, investors should focus on the energy and fertilizer sectors whose growth is strong and is unlikely to slow even if the economic sledding gets a little tough.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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